Solicitors who want to retain – let alone extend – their borrowing will have to shape up, think ahead and be prepared to ‘put some skin in the game’ if they expect any bank to fund them in future. That is the stark message from bankers and sector consultants, six years into the worst financial crisis the UK has witnessed in 100 years.
Law Society chief executive Desmond Hudson alluded to this challenge at May’s council meeting. Following the high-profile demise of firms including Atteys, Blakemores and Cobbetts, he said the Society had taken soundings from the major clearing banks about their willingness to lend to the legal sector. Although none reported having changed their appetite for lending, or a general decline in creditworthiness, a number of those questioned did admit reviews of the legal sector’s ‘attractiveness’ were imminent. He added: ‘Our focus remains to offer support and advice to firms worst affected, with work currently focusing on an accessible suite of key financial measures.’
Peter Gamson, partner and head of professional practices at Grant Thornton UK, believes law firms should not be complacent about the ‘rolling over’ of existing lending facilities. He said: ‘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. 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.’
Gamson’s view that firms – especially those forced to look around for a new lender – will increasingly be expected to demonstrate they are viable, stable and well run, is shared by Chris Marston, head of professional practices at Lloyds TSB Commercial. Marston says Lloyds (pictured) has not changed its stance on lending to the law, a sector he described as still in ‘green light’ mode. But it is, and has always been, the case that Lloyds will not accept just any firm on to its books.
He explains: ‘It is important for me to say that our approach has always been to lend in a way that is consistent and robust throughout the economic cycle. So it is probably fair to say that, in 2005/06, some people might have been saying "oh gosh, Lloyds are a bit dull and boring – they are not very adventurous". Well, we didn’t think it was our job to be adventurous. We preferred consistency and it is interesting that we now find that law firms are coming to talk to us because their bank has changed its criteria.’
Sue Carter, newly appointed head of professional services at Clydesdale and Yorkshire banks, is also clear on what she will be looking from law firms. She says: ‘For us there is one fundamental question to be asked and that is, "are you financially stable?". If the answer to that question is "yes" then you should be able to prove it. You must be able to robustly measure performance, both in terms of financial and non-financial aspects.’ She adds: ‘Non-financial characteristics include how the firm motivates its fee-earners, how it retains fee-earners, how it measures fee-earners. Does it have spare capacity both from a premises perspective and in terms of fee-earners?
‘The other fundamental is checking that all partners receive management information; that they receive it regularly; that it is of good quality; and that partners also have knowledge of what the office account balances look like.’ Marston believes that successful firms have certain key characteristics in common. Most notably, they keep right on top of their billing. He explains: ‘We have seen firms [implement] a programme to ensure everything that should be billed, is billed; and then every bill that is sent out gets chased and settled. By doing this, we have seen firms either greatly reduce or even eliminate their overdraft in a period of three months – just by being absolutely disciplined.’
Such firms are scarcely the norm across the legal sector, according to Marston. Many firms are reluctant to chase clients for money once the bills have gone out. Indeed, Marston believes the better firms are those that recognise that chasing money is not the job of fee-earners at all. He continues: ‘I am seeing a slight improvement in the willingness of partners to recognise that they need to leave that to people who are experts, which is welcome. Just as we have also seen a gradual movement over the years, at firms that are big enough to sustain it, toward having quality functional management. Why struggle with trying to run the firm’s HR, for example, when it is not your forte, and when you would be better off spending your time looking after clients and earning fees? Why not hire an HR manager to do it properly? Credit control and HR are good examples of where firms use functional management to do things that you do not need a lawyer to do, thereby freeing up that lawyer to look after clients and earn money for the firm.’
As well as being able to demonstrate that they are on top of their finances, Carter says that viable firms have to be able to articulate what their future will look like. While past sets of accounts will of course play a part in any lending decision, a firm has to be able to convince a bank that it knows where it is heading and the route it will take to get there. Marston adds: ‘When you are driving your car, do you do it only with reference to the rear-view mirror? Of course you don’t – you’d crash! And it is the same with business. You need some forward-looking forecasts as well, because that is how you know whether your ideas are going to work – whether you are going to be able to meet the cashflow needs of your business as it grows. And it also enables a banker to make an assessment about how we can best support you.’
The next component for a successful lending decision is what Lloyds’s Marston refers to as ‘skin in the game’. It is naive of limited liability partnerships to expect not to have to commit some of their own wealth to support any borrowing. Carter thinks the traditional partnership model has not helped the sector, because partners did not have to sign personal guarantees, although of course the banks always had recourse to take the ‘shirt off a partner’s back’ under joint and several liability. Reluctance on the part of LLP partners to sign personal guarantees or offer a debenture is unlikely to endear them to their bank.
Marston declines to give the current default rate on Lloyds legal lending book, saying only that law firms which have gone under have been well covered in the press. Lloyds was Cobbetts’s banker. He adds: ‘Wherever and whenever change comes, I am a great believer that there is opportunity as well as threat. Our customers who are doing well recognise that and are doing something about it. There are certain areas of legal work that are growing. Employment law would be one and family law would be another.’ Marston is also not averse to lobbying on behalf of legal practitioners. Lloyds contributed to the Law Society’s response to the Ministry of Justice’s consultation on price-competitive tendering.
He explains: ‘I think it is important for us to contribute to the debate. It is important that the government understands the issues that price tendering will bring for firms involved in criminal work. For example if a small firm has to gear up, in terms of purchasing a lot of IT equipment in order to interact with the MoJ through its digital portal, as firms will be required to do, that will need financing. That will mean going to a bank. Any bank will ask what certainty there is over the contract. The way things stand, the firm will have to say "I don’t know". And the bank will ask what the length of the contract is. The firm would have to say "three years", which might well not be enough to get a payback on the technology. So there are big issues here and we were glad to make our concerns known alongside the Law Society.’
While Lloyds and Clydesdale/Yorkshire are clearly still keen to lend to law firms, Carter and Marston both maintain that some other banks are turning off the funding tap. Moreover, the recent high-profile failures of firms such as Blakemores, coupled with the statement from the SRA that it has concerns about the financial viability of 20% of all solicitors’ firms, and it is hard to see how law firms could be considered a desirable investment prospect by the non-bank investment community.
Andrew Hedley, founding director of professional services adviser Hedley Consulting, is pessimistic about the attractiveness of law firms to external funders such as private equity. He believes the partnership structure, whereby ‘the concept of retaining profit and building capital value does not exist’, is fundamentally at odds with what any sensible external funder would look for when considering investment.
However, ‘traditional’ investment – that is putting up money in return for a share of future profits – is not the only way for an external individual or entity to make money from a law firm. Private individuals, government, UK councils and even universities have recently begun embracing a new way of making a return from small and medium-sized enterprises, including those in the legal sector: peer-to-peer lending. Dubbed the ‘new kid on the block’ among investment specialists, peer-to-peer lending essentially matches savers with investors looking for a return greater than would be obtained from an interest-paying bank account. For borrowers, it is attractive in potentially offering lower interest rates than bank borrowing.
What is peer-to-peer lending?
- A commercial peer-to-peer lender pools money from various sources (individual savers, pension funds, councils, even government) and lends it to businesses looking for a loan.
Interest rates (currently 7-10%) are often lower than those offered by traditional lenders, including banks. This is because peer-to-peer lending schemes are not ‘bricks and mortar’ businesses, but use the internet to bring lenders and borrowers together.
Fees are transparent – typically between 2-4% of the amount borrowed. Peer-to-peer lenders do not offer ‘add-on’ products such as swaps, insurance or hedging.
Time from application to funds being released is typically 12 days.
Funding Circle, at present the UK’s only peer-to-peer lender which will lend to law firms, only accepts applications from LLPs.
Funding Circle is to date the only UK peer-to-peer lender which will lend to law firms; although Zopa told the Gazette that it has plans to begin lending to sole traders in the near future and could extend this to larger businesses in due course. Funding Circle has been operating in the UK since 2010 and has so far lent £111m to UK businesses. Andrew Haldane, executive director for financial stability at the Bank of England, believes peer-to-peer lending will present a major challenge to the banks over the next decade and might even make their intermediated model of finance obsolete. Speaking to an audience in New York in March he said: ‘At present, these companies are tiny. But so, a decade and a half ago, was Google. If eBay can solve the "lemons problem" [substandard products] in the second-hand sales market, it can be done in the market for loans.
‘With open access to borrower information, held centrally and virtually, there is no reason why end-savers and end-investors cannot connect directly. The banking middlemen may in time become the surplus links in the chain. Where music and publishing have led, finance could follow. An information web, linked by a common language, makes that disintermediated model of finance a more realistic possibility.’
Funding Circle has to date lent a total of £500,000 to eight law firms; three from the north-west, one from the north-east and four from the south-east. Spokesman David de Koning points out that this was facilitated without any marketing to the legal profession and he expects to see many more law firms borrowing through the site in the coming years. He says: ‘What you are seeing now is more and more businesses who are not even attempting to go to their bank in the first place; because everything they have seen in the news appears painful and their experience of their banks over the last few years has been quite negative. So what we [Funding Circle] are experiencing is a lot of businesses just bypassing banks completely for loans. You will see that increasing.’
All of the firms used the loans to provide working capital. And de Koning disputes the suggestion that legal firms will suffer from Funding Circle’s supposed lack of knowledge of the legal profession. He continues: ‘I personally think the banks are a little bit stuck. On the one hand they claim they have expertise in the legal area, that they have people who can sit down with you and know your business inside and out. But on the other hand, the reality is that the individuals who sit down and talk to you face to face aren’t the decision-makers; they don’t get to give you the "yes or no" answer [about your loan].
‘By contrast, at Funding Circle the person who makes the decision about whether a business gets into our market will be the person talking directly to the business owner or finance director. And once in the market, lenders, who may well have a legal background, can talk directly to the firm they are interested in funding – which acts as extra due diligence for the crowd.’ He adds: ‘Our lenders will ask additional questions and can examine the financials in more detail if they want to. So I do think you are getting a real level of interest in each business. I don’t think banks claiming that they have "specialist legal advisers" makes them any better at credit – assessing legal businesses than models like ours.’
The funding process is two-stage: a credit expert from Funding Circle will vet a loan application for suitability and assign it a risk rating from A+ to C, usually within 24 hours of the application being made. Then it is put up in the market for seven days. At present the government is funding 20% of all loans on the market, through its Business Finance Partnership, and the remaining 80% of funds comprises the lowest bids from Funding Circle lenders.
So if a firm wanted to borrow £100, the government would commit £20 and the remaining £80 would be borrowed from the lenders offering the lowest interest rates. The borrower pays the aggregate interest rate of the lowest (winning) bidders. All the law firms who have been on the marketplace thus far have had their full loan request funded, seemingly proving that there is a willingness to lend to the sector.
For the bankers, meanwhile, Clydesdale’s Carter offers a note of encouragement that serves something of a corrective to de Koning’s pessimism about them: ‘There will always be good performers and bad performers, irrespective of the practice area in which they operate. As long as we have that understanding of the sector, we should be able to identify the ones which are the winners. Those are the firms which we want to support. We remain committed to working with both new and existing customers within the legal sector.’
Michelle McDonald is a financial journalist
WHAT ‘VIABLE’ LOOKS LIKE TO A BANK
Clear vision for the future, credibly articulated
Keeping ‘on top’ of billing
Partners willing to put their money where their mouth is