As the economy sputters along and the 'green shoots' of growth remain just that, many legal firms are struggling to stay afloat, let alone grow. Even for those finding opportunities to expand, the persistent issue of cash management remains a constant challenge and irrespective of your trading position, it remains less than ideal if you are having to rely on external funding, or indeed seek the permission of the external funders, to execute key business decisions. It's now become a sector norm for firms to carry heavily geared balance sheets and for many, avoiding the financial elephant in the room - cash outflows cannot exceed cash inflows - is no longer an option.
The legal sector has seen a number of high-profile failures in recent times. Unfortunately, this means that for firms with less-than-healthy finances, the ability to raise short-term finance is likely to be restricted in the coming months. Financial institutions are once again increasing their focus on their clients' ability to service their debt. The difficulties faced by the likes of Cobbetts, Halliwells, Dewey LeBoeuf and others should serve as a warning that law firms can, and do, collapse and that in the current market conditions, there is no respite.
With the July tax payment fast approaching, quickly followed by the annual professional indemnity (PI) renewal process (September), many firms will see their cashflow forecasts under strain and find themselves in a position where they will be seeking additional finance to smooth out their numbers. There are two primary routes to take but both may well present more of a challenge than in previous years.
The banks have had their fingers burnt many times over the past couple of years and are increasingly reluctant to extend overdrafts or provide short-term facilities to firms whose balance sheet and cashflow forecasts don’t inspire confidence. Simple extensions of an overdraft may prove unlikely for those who have habitually borrowed to cover these payments and the rates and conditions applied may be more severe than in the past. Understandably, banks are losing their enthusiasm to fund firms that show no sign of controlling their cashflow, and who continue to put profit distribution above other commitments.
This brings us on to secondary lenders. At this time of year, many of you receive significant numbers of calls and emails from secondary lenders, offering short-term funds that allow you to spread the cash impact of tax and PI payments. Our expectation is that the number that proceed to serious offers will be significantly reduced as secondary lenders are beginning to see that for firms in financial difficulty, the likely exit plan will involve a pre-pack administration.
In cases where the primary lender is significantly underwater at the time of the pre-pack, the secondary lender is not going to have the chance to be part of administration discussions and therefore has no control over the destiny of the firm; likely resulting in a very low return. This makes for a poor prospect when these lenders seek to get any funding requests through their credit teams and we anticipate a far higher instance of firms being refused credit right when they need it.
It has been common in the past for firms to rely on this sort of additional short-term funding. In the current market, leaving any conversation with a bank or secondary lender until late in the day is likely to lead to, at best, high rates and unfavourable terms, and at worst, an inability to raise funds in the future. Ideally, lenders want good notice. A potential borrower who is looking ahead at cashflows and proactively managing the funding requirement through early dialogue is always going to find themselves in a better position than those who appear to have been 'surprised' by the cash shortfall right at the last moment.
In the 'far from perfect' world we're now operating in, firms which aren’t showing:
- A strong awareness of short- and medium-term forecast cashflow
- A balance sheet with the underlying strength to indicate the loan can be repaid
- An approach to running the business that is focused on managing profits and cash rather than simply on extracting cash out of the business into the hands of partners
…will find the next couple of months very difficult to navigate.
What can you do to manage this risk?
1. Enter into a timely dialogue with your main lenders. Provide them with robust management information and forecasts and be prepared to discuss the business in detail with them. Give them confidence over your business model and show them how you forecast that their money will be able to be repaid within a sensible timescale.
2. Address the issues that are causing the underlying cash shortages. For most firms, you will need to look at employment costs and partner drawings. Reducing the headcount may be the medium to long-term answer for some but in the short term, most lenders would wish to understand that partners have recognised the need to reduce their drawings for the sake of the business’s survival.
3. Assess whether your firm is adequately funded by stakeholders. The legal sector continues to be significantly ‘under-capitalised’ by reference to other comparable-sized businesses outside the sector. A bank's appetite will become increasingly limited if the owners of firms are not committing significant amounts of their own capital.
What we would never wish you to do is risk the future of the firm by not taking positive steps to manage the situation. Leaving it to the last minute and hoping for a favourable outcome has always been risky, but in this climate, it may be a risk too far. If your cash position looks grey, has four legs and a somewhat long, nose-like appendage, it may well be time to acknowledge that the elephant exists.
If you don’t, it will be the banks and secondary lenders pointing it out to you.
Peter Gamson is a partner, and head of Professional Practices, Grant Thornton UK LLP