Part one: financial discipline is needed to prosper during economic recovery

With the Bank of England warning that the UK could plunge back into recession this year, how law firms manage their finances will be ever more crucial.

Even if governor Mervyn King’s grim warning of a possible ‘double dip’ proves overly pessimistic, management experts warn that coming out of recession can also be a dangerous period, particularly as professional services tend to lag behind the rest of the economy during a recovery.

So, can law firms prosper given the assaults they have faced on so many fronts – from the reduction in lending by banks and credit providers to the tough professional indemnity insurance market – and how can they better position themselves for the future?

Last year saw ruthless cutbacks in firms of all sizes. Its legacy includes 250 firms in the assigned risks pool, a far higher number than in recent years, with the vast majority being sole practitioners or two-partner firms. The number of interventions by the Solicitors Regulation Authority also increased from 48 in 2007 to 97 in 2009. In 14 of those, one of the grounds for intervention was ‘abandonment’ where the solicitors walked away from the firm.

Peter Scott, former managing partner of Eversheds’ London and European offices, advises law firms on financial and other management issues. He pulls no punches. ‘Law firms will need to reinvent themselves,’ he says. ‘Some people still believe things are going to come back as they were. But the world has changed and markets are going to be very different going forward.’

However, he says it is important not to paint too bleak a picture: ‘Those firms that made drastic cuts, got rid of staff and applied financial discipline over the last 18 months are doing well – one of my clients says it is going to be his “best year ever”.’

So far, law firms haven’t gone bust in large volumes, agrees accountant Robert Mowbray, of consultancy Taylor Mowbray: ‘The banks’ approach has been to apply “tough love”, making firms reduce the amount they are borrowing, for instance, but there is no evidence that they are pushing them under.’

However, even if the economy recovers, the danger isn’t over, stresses Scott: ‘Work starts coming in, firms think they must start recruiting, they have to finance more work in progress and overheads shoot up. Financial prudence must be the name of the game.’

Alan Hodgart, managing director of management consultants Huron (UK), agrees: ‘Insolvency lawyers say there are always more insolvencies in the upturn than in the middle of the downturn. People hang on during the bad times but then, when the market picks up, they don’t have the resources to compete.’

While some sole practitioners are struggling, others, such as Susan Singleton, who specialises in commercial, competition and IP/IT, have never been so busy. ‘It may be because there is a flight to ex-City lawyers for very specialist legal advice in niche areas who don’t charge City rates – I charge all clients £240 per hour plus VAT,’ she says. ‘It may also be because I am doing a lot of commercial and IP/IT litigation and litigators do well in depressions.’

For bigger firms, the need for financial discipline is equally strong. Andrew Clinton, managing partner of 25-partner south-east practice ASB Law, says the firm has analysed its service lines, scaled back the less profitable ones and invested elsewhere.

‘The traditional partnership model is essentially a fixed-cost business model,’ he says, ‘and, as such, it is highly vulnerable to a sustained downturn in demand. Many firms are looking at ways to convert elements of the cost base to variable costs.

‘What firms have to do is understand the dynamics of each business unit; decide whether they want to invest, divest or maintain – but drive the margin of – each of those units and then see those decisions through. Setting key performance indicators should help them react quickly if things go off course.’

Tony Williams, principal at management consultants Jomati, agrees. ‘In boom periods it is easy to get sloppy,’ he says. ‘Firms need to do a root and branch review of every practice area, every sub group, every client relationship, look at the level of experience and professional support, find any areas that may be leaking cash. Check time recording because the less you record, the less you bill, the less you recover. Make sure you are getting good cashflow projections and profitability analysis.’

Firms can prosper, says Frank Maher, a partner with Legal Risk Solicitors, but it will be ‘survival of the fittest’. He adds: ‘Those with outdated business models, insufficient attention to, or skill at, financial management will not survive. There will be a reduction in general high street firms and many solicitors will leave the profession through a combination of unemployment and disillusionment.

‘Others, however, will run highly profitable practices, particularly those with well supervised, non-solicitor staff handling volume business. We have sole practitioner clients with multi-million-pound businesses making profits which would be the envy of the largest City firms, who are looking to develop their businesses further with the Legal Services Act changes.’

What is clear is that financial management should underpin everything a law firm does. ‘The average small firm does their accounts in aggregate,’ says Mowbray, ‘but you need to do it by practice area so you can see where losses are being made. You have to be ruthless. You also have to drop the clients that cost you money and get better at negotiating fees with your good clients.

‘Since Christmas, I have seen several mergers starting between those with money in the bank who feel we have reached the bottom of the market and those in real distress who want an exit route.’

Hodgart also sees mergers as very alive: ‘But it should be done to add strength – it is not a pass out of jail.’

Given financial management is so crucial, do managing partners – and lawyers at all levels – need a deeper level of understanding of how it works?

Yes, says Clinton, whose firm runs profitability workshops both for heads of departments and within departments.

‘We are also introducing training on pricing as it is at the heart of what we do,’ he explains. ‘Lawyers can fall into the trap of regarding working capital management as a chore – but you need a culture within the firm that sees that as unacceptable.’

Financial management isn’t rocket science, says Scott. ‘There is a huge need in the legal profession for basic financial training – from managing partners down to trainees – on how to generate cash, how to make a profit, and how to cost work. A lot of clients want fixed prices, so partners should be dissecting completed transactions to see how long each aspect took.

‘Firms have also been “low-balling” just to buy in work. But that is madness. It is far better to look hard at your business, identify any overcapacity and cut it, otherwise it is a downward spiral as clients get conditioned to the low prices and you will never get them up again.’

Hodgart agrees: ‘You may occasionally say to a client that you will do some work at a discount so they can see how good you are but that any future work will be at the full rate. What clients want is certainty on pricing – in five years time, pricing by billable hour will probably account for less than 25% of legal work – so partners must learn to estimate properly. If a client disagrees, you need to learn how to re-work the estimate so you still get the work and make a profit.’

Firms have had to learn hard financial lessons during the credit crunch and they may have to stay attuned to lower drawings and the need to increase capital.

Maher says: ‘Partners frequently demonstrate a surprisingly disconnected perception of the link between money in the bank and money to pay their drawings. The firm has to come first. They cannot expect the bank to lend money against profit which has not been earned, and profit should not be treated as earned until the clients have paid their bills. Paying drawings on projected figures, which are unrealised, and on bills which clients have not been paid, is unsustainable.’

The prospect of alternative business structures (ABSs) will also put pressure on firms to get on top of their financial management – those seeking external investment may well find investors will want to impose their own finance managers who may be ruthless in seeking higher returns.

‘“Ruthless” is the wrong word,’ says Adrian Lamb, chief executive of Optima Legal, which has 12 partners and 257 fee-earners providing property and litigation services to over 65 lender brands. ‘Investors will insist on the business being balanced, stable and well run, and will demand greater focus on medium to long-term performance.’

External investors will want a return over and above what the firm is making for its partners at the moment, says Scott. ‘And where is that going to come from?

‘There is a movement downwards in terms of numbers of equity partners in law firms. Firms can’t afford to have too many snouts in the trough. It may be a cynical view but it is the advice firms should be taking to make themselves attractive to external investors. However, I am not sure what appetite there is among the investor side. Would I invest in a law firm? I am not so sure – certainly not one which isn’t well managed.’

Williams says ABSs could see firms taking advantage of outside capital to build up a war chest to devastate their rivals. ‘New entrants could be attracted to the retail end of conveyancing and probate,’ he says. ‘External investors could make a dynamic contribution if firms see it as a catalyst for change.’

But what about the small practices – the 83% of firms with four or fewer partners? What does the future hold for them?
Singleton, who has many law firm clients, says: ‘The small firm and sole practitioner can move swiftly to reflect market demand and the better ones will be absolutely fine.’

‘Small firms are far from dead,’ agrees Maher, ‘but they have to satisfy a need, and that may mean they need to be different. By way of example, at Legal Risk we differentiate ourselves as a law firm by offering a targeted service in specific areas – professional regulation and professional indemnity – which has a highly focused market – primarily law firms. Effective use of the internet and electronic communication also means there are no geographical boundaries.’

This is a watershed for law firms, says Scott. ‘It is about surviving and prospering. What kind of law firm do you want to be? The key is to be focused, whether you are a niche practice or a magic circle firm. It is about prioritising your investment and building your brand and your reputation – build that expertise and people will want to come to you.’

Grania Langdon-Down is a freelance journalist