• Auditing & tax
• Corporate finance
• Financial measurement
• Jobs & careers
• Risk management

• News
• Events

Feature

posted 28 Oct 2009 in Volume 4 Issue 1

No sooner have law firm managers developed a strategy for surviving the recession, than the next challenge appears on the horizon – reshaping firms to cope with the changes that the Legal Services Act 2007 will bring.

Many commentators have predicted a massive shake up of the legal market place over the next few years as large consumer-focused businesses enter the legal market. New entrants are already beginning to make their presence felt, even if it is only in terms of the number of column inches that are being devoted to them.

Is this Armageddon for traditional law firms, in particular medium-sized firms? Almost certainly not – if you look at other sectors that have gone through significant structural change, the one constant has been the continuing demand for the product and/or services – this is true no matter which sector you look at. By way of example, very recently, the Legal Services Board (LSB) has used the example of the Retail Opticians’ Services sector to illustrate that the upheaval in that market has widened choice, made opticians’ services more easily available and opened up new opportunities for opticians to sell spectacles as fashion accessories. The market has undoubtedly increased in size too.

As change embraces the legal sector, there are a number of areas that law firm managers should focus on: improving the firm’s business management; sharpening client (consumer) focus; engaging people; and, creating value in their businesses.

This article looks at a number of actions law firm managers should be considering in the each of the above areas in order to position their firm for the future.

Business management

The recession will have been a wake up call to partners that the business management of law firms is woefully inadequate to cater for seismic change over a short period of time.

Recently, the Lawyer 200 for 2009 was published and a quick review of firms in the south east (where we are based), ranked between 100 and 200, showed that fee income dropped for most firms with the average (including a couple of firms whose fee income grew) being a 16 per cent fall in fee income. For firms whose net profit margins historically have been below 20 per cent, last year would have seen profits wiped out, particularly if redundancy costs had to be borne.

Firms are going to have to become more efficient to retain good people, to have the resources to innovate and to satisfy ‘investors’ (partners and staff now, but also external investors once alternative business structures become possible) that their firm is capable of generating a decent profit.

Fortunately, law firms are relatively simple businesses and there are a number of actions that firms can do to improve business efficiency and underpin profitability. What should firms be concentrating on over the next couple of years?

Income is the result of turning work opportunities into actual work and achieving prices that are higher than the cost of the resources utilised in undertaking the work. It is not the result of an hours target for lawyers multiplied by their charge out rate less an allowance for write offs – the predominant budgetary tool used by law firms now.

If you aren’t measuring the work opportunities available to your firm (and putting a value on them) then you need to start doing so as this will tell you: first, whether you have enough opportunities to support the business strategy at any time; and, second, as experience develops of how many opportunities become work, how much effort needs to be devoted to marketing, where and by whom.

It needn’t be a complicated model, or expensive to maintain, but the payback will be significant in terms of confidence building, internally and externally, and in the ability to gear resources to meet expected business levels – five or six columns showing the client/prospect name, the status of the opportunity, the source of the opportunity, the projected value, the work type and who’s managing it should be enough for starters.

In the context of achieving prices that deliver a decent profit, another model will help firms to be more flexible in the future. In this model, you start with your current resource cost base and work out what income is required to cover those costs and achieve a suitable profit on top. Firms will need to know what work they’ve actually done in the past 12 months and make judgements about the likelihood of this being repeated the following year. Where there is a shortfall, this exercise will enable you to identify where your marketing resources need to be targeted – a more sophisticated model will also enable you to work out how changing the work mix, the resource mix and prices will change income.

A practical way to look at this is to imagine how you’d apply this model to your firm’s probate team. Past experience has taught you that, on average, 20 new probates will come from the firm’s will bank next year. You also know the actual number has ranged from 15-25 over the past five years. The average estate value is £1m and you charge a fixed fee of two per cent of the estate value for each. That equates to an average income of £400,000. If your resource mix currently costs £250,000, you will make a decent profit! You know, however, that income could vary, on past experience, from a low of £300,000 to a high of £500,000 given the range of probates the firm has undertaken in recent years. Your theoretical capacity is £450,000. Throw into the mix the fact that competitors (possibly new entrants, but it could be a firm in the same street) are offering to do the job for half your price (one per cent), how comfortable are you that you are going to turn a profit in the following 12 months? The model will give you a range of financial outcomes depending on the variables that you choose, but you will need to decide how you will respond. Your response is likely to be a combination of improving the efficiency of the resource base, looking for work opportunities outside your own will bank or innovating, such that your market increases in size or new markets become available. The one response you want to avoid is reducing your price, as that will inevitably lead to downward pressure on prices generally.

Interestingly, on the subject of pricing, a government-commissioned paper into the opticians industry in 2004 found that evidence on pricing was inconclusive. Thus, while the price of spectacles, contact lenses, and so on, had come down, and lower prices were accessible to everyone, they remained high for opticians who offered certain niche or specialised services. This is likely to be the case with the legal market place – prices will decline for commoditised work, but high value products and bespoke services will continue to command a premium.

On the resources side, firms might be forgiven for thinking that the cost cutting that they have undertaken over the past 12 months would be enough to position them both for recovery and to cope with the challenges that the new legal market place will throw up.

I am not so sanguine – we’ve recently seen in the Lawyer 200 some firms (Optima for example) who have made a decent profit for their small number of investors (equity partners) on a net profit margin of four per cent. If this is the scale of change that firms can anticipate, cost cutting will have to continue.

The challenge is significant. For firms whose margins pre-2009 were in excess of 20 per cent it will mean that all costs will need to be looked at again, and again.

In these circumstances, firms that believe their business model is akin to the Optima model are going to need to think in terms of savings in lawyer, secretarial and support staff costs that will improve profit margins by between two to three per cent each – that’s the equivalent of a cut of ten to 15 per cent in lawyer costs, and a cut of between 20-30 per cent in both secretarial and support staff costs over the next few years. These are very significant changes that won’t be easy to achieve. Time is the law firm managers ‘friend’ in this context as normal staff turnover will facilitate change on an incremental basis. Firms will need to use technology more efficiently and also outsource some services, in particular support services, which can then be purchased on an as required basis.

In terms of other costs a five to six per cent margin improvement will be required through savings in premises costs, general overhead and financial costs. Firms will need to be more flexible in the use of space, particularly as technology and modern working practices reduce the need for office space. General overheads will be saved by firms consolidating their buying power and financial costs will reduce as firms roll out more aggressive working capital management policies (and sanctions for those not complying with them) and start to retain profits to fund the firm, instead of relying on bank finance.

Even if you don’t think your future business model will correspond to Optima’s, you will still need to look carefully at all your costs for ways to improve margins.

Firms will also focus on leverage – the number of partners sharing profits. Firms in the top-100 have been reducing the number of equity partners in relative terms over the past ten years as the total number of equity partners has not changed significantly, yet firms are three times the size. Medium-sized firms are likely to have to reduce leverage over the next three to five years by a similar proportion. Fortunately, demographics are likely to help as many of the partners who are senior equity partners in such firms now will have been appointed in the late 1980s and will now be approaching their mid-50s and are likely to be considering a career change in any event.

Sharpening the client focus

New entrants have already recognised that there is a limit to their ‘brand stretch’ – the extent to which they can use their brands to draw consumers away from traditional legal service channels. They have so far focused on specific segments of the market – people with straight forward legal issues, such as conveyancing, wills, personal injury, probate and divorce, all of which lend themselves to call centre processes or technological solutions and increasingly require people to use the internet to access the service.

The LSB has identified some business organisations that may employ solicitors themselves and charge members for the service – this could be done now if firms were prepared to innovate in this way. This approach is already in place in parts of the public sector where a number of firms have deep-seated relationships with educational bodies and local authorities. In the private sector, there are a number of organisations that use employment law services to provide advice in relation to employee legal issues and insurance cover for claims.

These organisations will look to extend their offering over time. However, the biggest barrier to these firms increasing their market share is the fragmented nature of the market for advice to mid-to-high net worth individuals and small to medium sized businesses, and the significant risk profile attaching to clients in these markets as a result of their more complex problems and the higher monetary values at stake.

This presents an opportunity for law firms. The challenge will be to focus entirely in those markets that require high levels of personal service, where firms can build a deep understanding of their clients’ specific needs and where firms can develop relationships with complementary organisations working in the same markets.

Research in the banking sector has shown that many people and organisations abstain from seeking out relevant services if they cannot identify a suitable provider – this focus may create opportunities to increase the size of the market.

These clients will be sophisticated enough to want to participate in the provision of services. For example, in the case of a private client requiring a will, clients are likely to input details of their assets, liabilities, dependents and wishes into a secure database and smart technology will then produce options that an experienced lawyer will work through, face to face, with the client.

On the business side, lawyers will work closely with clients in a trusted adviser role. Some services will be provided free, especially latent knowledge, largely through the internet. Otherwise, firms will be able to demonstrate, through their deep understanding of their clients and the sectors in which they work, value and thus price their delivery accordingly. Firms will need to take on more risk as a result and will have to take a long term view of relationships.

Firms will forge close relationships with other professionals serving the same markets, be they business coaches, accountants, banks, and so on. These relationships will be a source of expert help to clients who will value the close association between professionals who understand
their needs.

Engaging people

People throughout the firm will be a source of competitive advantage for firms and will need to be enthused and engaged about the firm they work for or they will increasingly seek out better organised competitors.

Alignment will become the watch word for engagement in a modern law firm – gone are the days when lawyers cherished their autonomy and their ability to ignore ‘management’.

The role of a partner has changed forever. Partners must be leaders and role models for the rest of the team. Partner performance is now routinely measured, with more advanced firms valuing a wide range of partner skills through the use of a balanced scorecard, which encompasses objective financial and business development criteria, and more subjective leadership and role-model based criteria. Very advanced firms are scoring partners under these systems and ranking partners performance compared to their peers. This is a necessary step as it will ensure that partners are able to develop the wide range of skills that are so necessary to achieving the flexibility to compete in the brave new world.

Partnerships will need to be expanded to include non-lawyers as their wide-ranging business and management skills become more critical to the success of the firm.

The current generation of lawyers will need to develop general business skills and will be required to build relationships with clients, targets and other professionals, and demonstrate an ability to innovate in order to show investors that they can add value to the firm to justify their promotion to partnership. Good technical skills will be taken for granted and won’t be seen as value enhancing.

There will be increasing emphasis on outsourcing. This will apply to secretaries and support staff initially – this is a positive move for the staff affected. In the case of secretaries, outsourcing of repetitive tasks such as typing will mean that their continuing role will be more demanding and challenging. In the case of support staff, the outsourcing of their roles will give them the opportunity to develop careers that would otherwise only be possible by changing jobs, which carries risks for the individuals and for the firms they come from and go to.

Creating value

The emphasis will be on creating value in the firm that can be used to incentivise people and provide a reward to investors.

For existing medium-sized firms (firms from 100 to 200 in the Lawyer 200) this means maximising profitability across the whole business. Presently, many such firms offer a diverse range of services to different segments of the legal market – for example, firms with a legal aid franchise also provide high-net -worth private clients with similar services. Firms are beginning to realise that there are significant differences in the skills required to manage such services and operating in several different markets places a strain on firms’ infrastructures. Thus, the ability of each group to earn a consistent net profit margin and profit-per-partner is compromised. This creates tensions in the business and leads to sub-optimal performance overall. Firms will seek to simplify their business models and focus on services that are targeted at compatible groups and are similar in the way they are delivered, thus maximising the efficiency of infrastructure resources and ensuring that each group earns a consistent net profit margin and profit per partner. This will maximise profitability in the long run.

Those groups that are incompatible with the core services will be encouraged to de-merge so that they can operate more efficiently on a stand alone basis or with other similar groups. This happened to private client practices in City firms in the late 1980s and it is likely to happen to the more commoditised services of medium-sized firms over the next few years.

Consolidation will also present firms with an opportunity to create value in the merged entity over and above the value of the two separate entities. Value will come from a number of sources, infrastructure savings being the most obvious source. Value will also come from spreading risk in relation to client, partners and staff defections – investors will be more comfortable if no single client contributes a sizeable proportion of a firm’s income and if there are several teams providing similar services to clients. Ultimately, consolidation is likely to lead to opportunities for firms to access external capital to fund further growth and infrastructure spending, which would otherwise have to be provided by partners themselves. I think it’s unlikely that external investors will want to invest in a range of unconnected firms; the accountancy profession tried this in the late 1990s and the early 2000s and the initial attempts to do so were not a success.

In summary

Unquestionably, the landscape for medium-sized firms is going to change significantly over the next few years. This article has outlined a number of challenges that law firm managers should address to help their firms adapt to the new order. The firms that will create value for their investors will be the ones who have become more efficient as businesses, who really understand the needs of their markets and who have engaged people throughout the organisation. The best firms will already be well down the path.