denotes premium content | May 21 2012 Feature
posted 5 Sep 2008 in Volume 2 Issue 6
Exchange rate fluctuation in the context of partner remuneration
Foreign exchange issues can present problems in the context of partner remuneration. Various internal methods can, however, be employed to successfully address the challenges. By Michael Roch and Clive Zickel.
The effect of currency fluctuations on partner distributions has caused dissatisfaction within several international firms operating a global profit pool. While US firms tend to struggle more with this issue than their European counterparts,
Why some partners feel poor
Law firms with global profit pools are most affected by the recent rapid strengthening in the euro: least affected are the international accounting firms, because they tend to rely on local, country-based profit pools (even when regional operations are merged).
So far, the euro has been the winning currency of the decade. Since 2000, the euro has appreciated by about 43 per cent, or more than 5 per cent, per year against the dollar; one third of this gain was realised in the past two years. Against sterling, the dollar also lost its value, although at a more moderate 22 per cent. In 2007, sterling lost 16 per cent against the stronger euro. Reasons for the euro’s appreciation include the substantial initial undervaluation at the time of its inception: once it began to assert a major role in international finance, consistent European growth coupled with an American slow-down, due to
Emerging markets
The combination of currencies in which a firm operates will therefore drive the degree to which the effect of exchange rate fluctuations on partner remuneration needs to be managed.
Available options for addressing exchange rate differences
Global corporations as an example
International corporations provide only limited guidance for most law firms. While they operate one global profit pool, international corporations do not distribute most of their profits to senior executives as is the case with most professional services partnerships. Instead, in simple terms, corporate pay is based on effort (salary), short-term performance (bonuses) and long-term performance (stock grants). While salaries (and in some cases bonuses) of executives living abroad may be indexed to accommodate higher costs of living, these individuals do not share in the global profits of their company: shareholders do, and they are left to their own devices on how they protect their foreign investments from exchange rate fluctuations.
Risk allocation and complexity
With exceptions, global partnerships do not generally leave their partners to their own devices. International firms have developed various approaches to this issue, and an informal Kerma Partners survey conducted at the beginning of 2008 established that no industry standard has yet developed around how firms treat currency issues in the partner remuneration context.
While foreign exchange allows for mind-boggling economic modelling, it appears that management of foreign exchange in the context of partner remuneration can most easily be analysed across two dimensions: risk allocation and complexity. First, the risk that a currency moves one way or another must be allocated rationally among individual partners and the firm, and therefore the partnership as a whole. Second, the method of risk allocation must be sufficiently simple for busy – and non economically-minded – partners and managers to understand both at home and abroad. Any change in the firm’s policies regarding partner-remuneration-related currency should be treated as a change in the firm’s remuneration system, even if the partnership agreement provides management with discretion to effect changes without partner consent.
The principal alternatives are discussed below.
Arbitrary reference rate
Many firms have established a reference rate, which they use to convert earnings in the firm’s reporting currency, as the basis to calculate the amount of distributions paid to foreign partners. The exact methodology varies significantly: some take a more or less arbitrary rate; some base the rate on a two, three, five or even longer historic average; and, others fix the spot rate at the beginning of the year to govern the remainder of the financial year or some other period of time.
The key advantage to this approach is its simplicity: one base reference rate is easy to explain to partners at home and abroad. This approach self-adjusts over time and balances foreign exchange risk more or less evenly between firm and foreign partners. When the firm’s reporting currency depreciates, the local partners are at an advantage, and, when it strengthens, the firm benefits. This approach works reasonably well until there is a rapid decline in the firm’s reporting currency as we have seen over the past 12 months with the dollar and sterling. Partners who get paid in the firm’s reporting currency are led to believe that they are subsidising their foreign partners even if performance among the two partner groups is at par, and foreign partners overestimate their financial contribution to the firm in real terms, potentially causing material dissatisfaction on both sides.
Collar or cap
Some firms have ring-fenced currency fluctuations by floating partner distributions at the spot rate until a chosen reference rate is reached. Once the firm’s reporting currency depreciates or appreciates beyond that reference rate, the partners are paid in foreign currency at that outside reference rate. The reference rate is reset periodically: the range of exchange rate fluctuation is anywhere between 1 per cent and 2 per cent per annum. The purpose of this method is to limit the exposure of the firm to minor short-term changes in the firm’s reporting currency. If, however, there is significant fluctuation over a short period of time, it causes difficulties similar to the arbitrary reference rate.
Some firms combine the collar with a limitation on the amount of currency difference that is paid. There are myriad variations to this approach: one global firm, for example, pays its partners’ currency differences out of the firm’s bonus pool, with the amount being capped at a percentage of the bonus pool that is available.
Both methods provide some predictability of exposure by both the foreign partner and the firm, and they work well where currency markets are relatively stable. A cap is slightly easier to implement than a collar arrangement, but a collar arrangement may, because of its more reciprocal nature, appear fair to the partnership.
Purchasing power
Some firms increase the amount of partner distributions on the basis of the purchasing power keyed to the city or the office to which the partner is assigned, and not on the basis of exchange rates. This method can work well in firms where partners are paid a notional salary that is adjusted on a ‘cost of living’ basis while allowing distributions above that amount to float with the spot rate.
This method is a little more difficult to implement. First, the relationship between exchange-rate differences and ‘cost of living’ differences is not always apparent. Second, the availability of reliable ‘cost of living’ indices very much depends on the city of the office. A reliable ‘cost of living’ comparison between
Other options
Other options include a nominal currency basket that is weighted similar to the currency basket used by some countries as a means to fix their exchange rate. While presenting the fairest option to all partners and the partnership, most firms lack the systems to implement a nominal currency basket across all performance layers of the firm.
Separating profit pools on the basis of currency also provides for a simple option, especially for firms that do not have fully integrated operations. Many law firms, and all major international accounting firms, maintain separate profit pools for various reasons, often on a country-by-country basis. In our view, however, solidifying partner behaviour towards a global profit goal should take precedence over adjustments in the firm’s compensation system to accommodate currency fluctuations.
Risk allocation to a third party: hedging
Some law firms leave currency risk entirely in the hands of their partners – and let them deal individually with how to best mitigate this risk. Practically speaking, some financially astute partners hedge their currency exposure: most do not. Recently, international banks have worked hard to provide customised hedging solutions to their global law firm clients and their partners, similar to how large corporations transfer the risk of exchange rate differences to third parties.
Where firms are already paying a differential between an out-dated, historically determined rate and the current spot rate, a hedging arrangement will not help reduce the difference (typically a firm-expense). However, hedging can help reduce the burden on a going-forward basis: misplaced conservatism aside, there is no reason why larger firms should not be hedging their operating cash-flow requirements and their distribution payments to foreign partners.
Firms that are uncomfortable with hedging themselves have begun to educate their foreign partners in the options available to them. Most private banks offer some type of currency hedging, and foreign partners can easily hedge all or a portion of their profit distributions against a decline in the firm’s reporting currency usually for a period of up to two years. Some firms take the middle road and contract with their bank for a hedging platform that can then be used by their partners.
Addressing the impact on partnership tiers
We want to highlight that hedging can only mitigate the differences in cash that a partner receives as a result of exchange rate fluctuations. Hedging does not provide a solution to the larger problem of the partnership structure. A sterling-based partner, for example, would still move up the partnership tier if his sterling performance is translated without adjustment into dollars and evaluated by
Without a significant amount of expectation-management and education on all sides, the
A well-structured performance management system that sensibly accommodates foreign exchange rate fluctuations in the context of the partners’ contribution to (not remuneration from) the partnership is a pre-requisite to ensuring that these disruptions are minimised.
Performance management in the multi-currency context
Once a firm goes global, more than just opening or acquiring its first office is required. The firm’s performance-management system must now accommodate the fact that the firm is an international firm, addressing myriad issues, including currency, tax equalisation, pricing and rate structures, and many others. For the firm to handle currency aspects related to performance management, several critical issues must be addressed:
Education
Domestic partners who have never had to think in a different currency, and whose practice is often entirely domestic, need to be gradually educated in the effect of foreign currency on the firm’s performance and that of their partners – if the firm has an open compensation system. This is to avoid factually incorrect misperceptions that are difficult to cure later. This training is most easily undertaken as part of the firm’s financial management curriculum. Partners who have a performance assessment role or sit on the remuneration committee, and leaders of global practice groups also need to be particularly competent to address currency implications related to how performance is reported.
Information management around currency impacts
Firms often do a sub-optimal job of managing information flows on how currency affects performance measurement in the remuneration context. This issue often leads to misunderstandings on all sides: partners of already profitable foreign offices are lead to believe they contributed more to the firm’s profits than they actually did, while domestic partners are threatened by European partners moving up the lock-step primarily because of an uplift in reported earnings that is due to a favourable movement of the local currency against the firm reporting currency. At the same time, home-office partners are led to believe start-up offices cost more than they actually do in real terms, while local partners like to fudge initial results by pointing to the large gains in revenues shown in the firm’s reporting currency.
Transparency
Unequal treatment of groups of partners can cause friction unless there is a transparent rationale for this difference in treatment. This often arises where international operations are grown through acquisitions. Special arrangements, such as a fixed exchange rate, are sometimes made for senior partners, locking in a more favourable rate for them than for other overseas partners. Especially in remuneration systems that purport to be open, it is important that currency adjustment arrangements are transparent.
Treasury and systems
Global corporations tend to have reasonably sophisticated treasury management functions in place that enable the company to address currency management. An experienced treasurer becomes essential for the firm to manage its global cash. In addition, good decision-support systems (preferably those that did not bolt-on currency modules but that were built around multi-currency businesses from the beginning) are key: as are analysts that are internationally competent.
Finding an individual permanent solution
It is our viewpoint that partners are owners of their firm. They are not paid employees, even though they often consider their remuneration to be their ‘pay’, their compensation for the pain and suffering caused by the toil of their labour.
To arrive at a solution that addresses foreign exchange in the context of partner-pay in a way that appropriately balances risk between firm and partner and that is relatively straight-forward to implement, a careful analysis of the partnership’s structure, the objectives of its remuneration system, its historic treatment of the issue of currency and the various structural and third-party options must be undertaken.
No matter how a firm addresses the issue of currency in the remuneration context, it is key that, while encouraging behaviour that supports the firm’s global strategic objectives, the solution solves the issue in such a way that does not need revisiting once the current dollar/sterling/euro situation reverses or if the global-partner complement materially changes.
Michael Roch and Clive Zickel are both senior advisors at Kerma Partners, the international consultancy. They can be contacted at michael.roch@kermapartners.com and clive.zickel@kermapartners.com
