The trend towards fewer equity partners at the top law firms means financial growth figures may not be as healthy as they appear, writes Cameron Timmis


Last year was a bumper 12 months for many of the country’s big law firms. All the signs are that 2007 could be another very successful year. But according to accountancy firm PricewaterhouseCoopers (PwC), author of the widely respected annual survey of the largest law firms’ finances, a number of ‘worrying’ trends are emerging that could put many under increasing pressure (see [2006] Gazette, 23 November, 8).



It is true, PwC acknowledges, that the headline figures in the 2006 report are strong – exceptionally so, in some cases. Take profits per equity partner (PEP). Last year, every top-100 firm grew PEP – and 30% of them by more than 20%. This translated into some staggering figures – more than half of the partners at top-25 firms earned more than £500,000 last year, and at a quarter of the top-25 firms, each partner pocketed more than £750,000 on average.



Earnings were almost as impressive, with 84% of the top 25, and 57% of the top 100 increasing revenues by more than 5%. Firms in London and Scotland were particularly strong, although the midlands, south-west and Wales fared less well.



The report was based on responses from 57 of the top-100 firms, including nine of the top ten, and 21 of the top 25.



Yet dig a little deeper, says PwC, and a rather different and surprising picture emerges.



For example, in 2006, gross profit margins (profit after fee-earner costs) dropped in all but one of the seven practice areas examined (the exception being insolvency), and was particularly marked in intellectual property, construction and banking, where margins slipped by as much as 10%. In terms of net profit margin, which includes indirect overheads such as premises, the picture was not quite as stark, but still troubling. Among the mid-tier firms in particular, ‘net profit margins remain under pressure’, the report claims.



How can this be, given the benign economic climate for commercial law firms? Alistair Rose, joint head of the professional partnership advisory group at PwC and an author of the report, offers three possible explanations. First there are escalating salary pressures because of the buoyant market. Then there is high staff turnover, which leads to increased recruitment and training costs. Finally, he says, there has been a reduction in chargeable hours billed by law firms.



Each of these factors, explains Mr Rose, is putting ‘real pressure’ on many firms. ‘The headlines are great, but there are some structural issues that firms have to have a long hard look at.’ Increasing salaries are a particular problem for the biggest firms, where ‘worryingly’ nearly a quarter of those polled recorded staff salary costs of more than 45% of fee income. Similarly, staff turnover in many law firms has become almost a stampede, with, in some cases, firms losing more than 30% of the workforce per year. That is a huge drain on the bottom line, given, as the report says, that the costs of recruiting a lawyer with the recruitment fee, training time and loss of chargeable time may exceed 100% of the salary.



Most perplexing, says Mr Rose, is the reduction in chargeable hours identified in the report, technically known as ‘utilisation’. In 2006, the number of hours billed by lawyers at top-100 firms, at all levels, declined by an average of 3%. For example, the hours billed by a five-year-plus qualified lawyer dipped from 1,362 to 1,306. Mr Rose suggests this could either be a result of a higher turnover of lawyers, which causes inefficiency, or simply that some lawyers are choosing to work fewer hours. ‘The younger generation tend to have a different outlook on the work-life balance,’ he says.



PwC is not a lone dissident voice. A report soon to be released by legal consultancy Hildebrandt International, Challenges in the UK mid-market, has arrived at many similar conclusions.



‘There are a very significant number of firms where the profit margin is in decline,’ says Hildebrandt consultant Giles Rubens. ‘There is downward pressure on fees, and upward pressure on costs. It’s happening to all sorts of firms but particularly in the mid-market.’ He adds: ‘Especially from firms 30 down to 100, there is a high percentage of practices suffering a declining margin.’



Mr Rubens says a common problem in many firms is that senior lawyers are doing work that could easily be handled by more junior (and cheaper) lawyers. ‘That can have a very significant impact on profitability,’ he says, ‘but law firms find that very difficult to deal with.’ Property costs are also an increasing burden, he suggests, as many firms feel the need to refurbish premises to meet client expectations.



However, Mr Rubens does not pay much credence to PwC’s finding that productivity – measured by chargeable hours – is in decline. Instead, he suspects that firms may be intentionally recording less time on some matters.



The downbeat conclusions of both studies seem puzzling given the widely reported record-breaking profits at most law firms last year. Mr Rubens attributes this apparent contradiction to a ‘myopic’ focus on a single financial indicator – PEP. He says that firms can easily manipulate the PEP figure to raise partner profits – by cutting the number of equity partners – and thereby obscure an overall decline in performance. ‘It [PEP] is an important measure, but it is just one measure,’ he says.



Similarly, Mr Rose says it is important to look closely at how firms have achieved such high levels of PEP. A key finding in the PwC report is that while revenues at the top-25 firms have increased by nearly 50% in the past three years, the number of equity partners has only grown by 11%. Last year, in fact, more than half of top-100 firms actually reduced their tally of equity partners. In short, although firms are growing fast, the proceeds of growth are being shared in fewer hands. Equity partners currently make up about 16% of a firm’s lawyers, according to PwC’s survey.



Keeping such a tight rein on the equity may be good for the current crop of partners, but Mr Rose warns that, in the long term, this ‘model’ may be difficult to sustain. ‘It’s not just about sharing the cake, but having future leaders of the business,’ he says. ‘You need to bring people through, and they need partnership as an objective.’ In addition, he says, ‘you would expect firms to be investing in the partnership in a good economic environment’.



Nor does Mr Rose think that increasing the number of salaried or so-called ‘fixed share’ equity partners, as many firms have done in recent years, will prevent the most able junior lawyers from leaving a firm, if a firm keeps its equity partnership unduly restricted.



Perhaps law firms are already taking some of PwC’s advice on board. According to Paul Stothard, chief executive of Shoosmiths, a regional firm that has received plaudits for its rapid growth over the past few years, there has to be a balance between aiming for high profits per partner and overall profit growth. ‘We talk about this quite often,’ he says. ‘We are a firm of 1,300 people, of which only 40 are equity partners. PEP is an important measure of success, but you can quite easily increase PEP by cutting equity partners, and that smacks of short-termism. At Shoosmiths, we have proper appraisal and performance measures. That’s what drives the number of equity partners, not profit per equity partner.’



Mr Stothard predicts that the biggest issue law firms will need to face in 2007 will be how to tackle the work-life balance issue and continue to motivate lawyers when pursuit of profit may no longer be enough for them. ‘There are people saying that [money] is not going to do it for them. There are people saying it is not worth killing themselves for the sake of profits. Everyone talks about work-life balance. The big challenge going forward will be coming up with a package and career that suits the individual.’



Cameron Timmis is a freelance journalist