Avid readers of the English legal press may recently
have seen a lot of agitation about an international law firm, Dentons, and one
of the commonly seen measures of law firm financial performance, PEP (profit
per equity partner - in the USA, PPP).
The agitation concerned Dentons' refusal to provide an
American legal magazine, American Lawyer, with their PPP figures for all
jurisdictions where they operate (this information is public only in some
jurisdictions,). American Lawyer (Am
Law) drew some adverse inferences about this refusal, Dentons responded to the
effect that Am Law’s articles suggested they could not be trusted with a
calculator, and there followed another round of back and forth. More Am Dram than Am Law, some might
say.
PEP is very interesting and relevant if you are, for
the year in question, the statistically average partner, because it represents
what you earn that year – even in the same firm, however, other partners’
returns may be greater or lower. It's
also very interesting for the managing partners in the firms concerned because
it gives something with which to compare themselves against their rivals, and
it provides prurient sources for copy for the legal press.
What PEP doesn't reveal, in any meaningful way, is how
the law firm has really performed in that year, or what its financial health is
really like.
It doesn't give a really accurate index of performance
for the year because it is so easily distorted by the number of equity partners
in the firm – the same overall profit figure produces a much bigger PEP for a
firm with tighter equity than one with more equity partners, even if other
figures more indicative of the firm’s performance as a unit – such as
expressing profit as a percentage of its overall revenue – favour the second
firm. In the wider business world, there
may be many more lines on the financial position of a company than its profit
to revenue ratio, but a company with a higher percentage of profit to revenue,
all else being equal, is regarded as healthier.
The wider business world - there's a thought. Acres of space is devoted to the analysis of
the financial performance of companies, some of it on this year’s profit for
sure, but also to their balance sheet. This
leads to my second point about PEP’s limitations as a measure of financial
performance – it gives no insight into the firm’s long term financial
stability, only how it performed in the given year (and with the weaknesses
noted above).
In that wider business world, balance sheets speak
loudly. Providers of long term contracts
find their potential clients checking their balance sheets, to satisfy
themselves that they will be around long enough to perform. The law firm world has operated in a
different medium for decades. Historically
law firms have not had many long term commitments – few long-term contracts and
other than property rental, most other commitments were of the sort that turn
up on a Monday and can be fired if the work dries up. There have been exceptions of course - Dewey
Leboeuf being the most startling by stacking up long-term commitments to
laterally hired partners. It's worth
noting that in March 2012, they reported their PEP figure for 2011 in excess of
£1 million. By May 2012 they had filed
for bankruptcy. So much for PEP as a
measure of their financial health – with the vast majority of each year’s
profits paid out to the equity partners, past profit has a limited impact on
current financial resilience.
But as the practice of law evolves, the investment
needs of law firms are evolving too, and as law firm margins are subjected to
pressure from new entrants, different retainer structures, harder-nosed GCs and
other factors, firms may find that, like other service providers in other
businesses, they have to flex their business models and retain more profit to
support their investment and other financial needs for future years.
There's a role for in-house lawyers in this. As technology drives increasing intimacy
between law firms and key clients, the consequences of law firm failure become
more acute. It will become less simple
than paying the work in progress on a file to get it released to a new
firm. So when striking relationships with
firms which they see as long term advisers to their employers (as opposed to
one-off instructions for short-term deals), they should think about the desired
longevity of the relationship and the ability of the law firm to fulfil it.
They should look at (or ask for) the law firm's accounts and scrutinise the
balance sheet just as much as this year’s profit.
I started by referring to the UK legal press, and I am
going to end by quoting from Legal Week (20 June 2014 – “Dentons vs the legal
press: partners react to PEP row”). The
article quotes various leading partners in leading law firms on the use and
abuse of PEP. I was impressed by the
reaction of K&L Gates' Peter Kalis - "... We'll know that our industry
has matured when the leading industry publications begin asking for balance
sheet information and other financial indicia... Such information gets to the heart of a law
firm's financial health, and its public scrutiny can prevent law firm
failures."
Hurrah. That's
a forward thinking statement. I think
the market will also have matured when the provision of financial information
by law firms to prospective clients is seen as a normal process of winning
work. That maturity lies in our hands as
clients – we should look at our advisers’ financial statements – if we don’t
like what you see or, worse still, don’t see anything, then it may be time to
change advisers. Reading about a law
firm’s failure is bad enough, without being involved as a client.
