Feature

posted 9 Feb 2009 in Volume 3 Issue 3

2009 – a recession, a depression And an ailing profession?

By Joanna Lee

As 2008 turned into 2009, certainly this year, rather than new beginnings, brings with it the end of many careers, the demise of some firm practice groups and a whole lot of management resolutions.

As we face the introduction of legal disciplinary partnerships (LDPs), I’m sure back at the inception of the Legal Services Act (LSA), no one imagined we would be in the position we are now in – although there’s no time like the present for change and a little extra cash(flow).

So what exactly does 2009 have in store? Well, so far the UK is officially in recession, and the laughable comparisons with the Great Depression are not quite so humorous now. Having devalued to such an extent that it sank close to parity with the euro, Sterling had a brief moment of appearing on the up – sadly this was not to be.

We watch the week-by-week deterioration of the euro zone economy, and our European counterparts are one step behind us in slowly, but surely, plunging into recession. The UK reduced its benchmark interest rate to 1.5 per cent, the lowest in its 315-year history. And finally, the government just announced its second bank bailout.

So, how has the legal profession fared and what is in store for 2009? With a little help from some FD Legal friends – George Bull, Kay-Uwe Bartels, Norman Green, Adrian Jennings, Jon Miller, Giles Murphy, David Snell and Keith Wood – we look at how firms fared in 2008, what 2009 holds in store, the opportunities available and the consequences for the legal profession.

2008 – how was it for you?

Going back to the first half of 2008, in particular April 2008, PricewaterhouseCoopers’ (PWC) Annual Law Firm Survey 2008 showed record results, profitability and increases in fee income. 2008 seemed to be an all-round great year, particularly for top-ten law firms. The four previous years showed year-on-year increases in fees and profits, and firms were planning along the lines of that continuing – some were maybe more realistic and some took the view that it might level out, but certainly no real change from an ‘onwards and upwards’ type of trend.

“We saw firms outside the top-ten struggling to keep up and endeavouring to do so by recruiting pretty heavily in anticipation of continuing buoyant economic conditions”, says David Snell, a partner at PWC, who specialises in professional partnerships. And with heavy recruitment came the expansion plans to accommodate, bringing increased payroll and premises costs.

It seemed that the only way was up – unfortunately for those that budgeted and forecast for a continuing buoyant market, this was tragically not the case.

The second half of 2008 saw the credit crunch really take hold, and although end-of-year results were still strong, and some touted 2008 as the ‘best year ever’, this did not paint a true picture of what was happening.

As of September 2008, the world changed dramatically, and for the majority of firms, as the year progressed, things rapidly deteriorated. “Firms with any transactional work, IPOs or corporate transactions, have seen a very rapid drop-off in work”, says George Bull, head of Baker Tilly’s professional practices group. “Property has suffered, residential conveyancing has been dramatically hit even at the high end, and for most commercial property teams, the precipitous decline in transactions has been devastating.”

Global firms with a big international presence seemed to be holding up well, with their international offices mitigating the reduction in UK revenue, as other economies were slower in joining the downturn: the emerging markets, in particular, were deemed recession-proof.

And with the euro going from strength to strength at the end of 2008, those with European offices found the strong euro proving extremely helpful to profits. Unfortunately, it was merely a matter of time before the downturn became truly global, and not even an international presence, nor an emerging market, was enough to make up the shortfall.

Even those areas that shouldn’t have slowed down (for example personal injury) have been hit, as they are finding difficulty in obtaining money from the banks. “If your business model relies on continuous growth to maintain profitability, then if credit is not easily available, profits may not be so easily available either,” says Bull.

Those running a counter-cyclical business seemed to fare better, as Adrian Jennings, head of finance at Cripps Harries Hall LLP, explains: “We have some counter-cyclical elements to our practice, which means it hasn’t been all bad and those areas that have found conditions tough have found it so at different times.”

Logically, it would follow that with corporate transactional work and property declining so rapidly, litigation and recovery work would have picked up just as rapidly – however, this didn’t happen as quickly as expected and only recently have things started to take off. “In the past month or so we have seen our insolvency practice getting very busy,” says Norman Green, chief operating officer at Herbert Smith LLP, “there has been a significant increase in the number of enquiries and a couple of major instructions secured, so that means we’re taking staff out of other parts of the firm to assist in this area”.

And as 2008 drew to a close, the headlines were dominated by redundancies. Following some heavy recruitment outside the top-ten, in (unfortunately incorrect) anticipation of continuing improvement in economic conditions and activity “there is now too much capacity on hand that they are having to cut,” explains Snell.

Firms are trying to make no more than one round of redundancies until April, and it would seem that what happens from now through to the end of April will be critical in terms of what sets the tone for 2009.

So what does 2009 hold in store for the legal profession?

The defining financial feature of 2009 will be the extent to which banks begin to lend to each other and to businesses again. When they do, confidence will slowly return and activity levels will increase – although, without question, until then banks will be taking a much tougher line when it comes to extending credit to firms and liquidity could take a noticeable hit if banks withdraw overdrafts, tighten credit, loan and working capital facilitates or add punitive interest rates.

For firms, sustainability is key this year, as is managing cash and lock up: also a focus on careful, realistic budgeting and cost cutting, while not having a short-term knee-jerk reaction to the recession and risk damaging the firm in the long-term. “There will be initial enthusiasm in the early downturn to radically overhaul the law firm business model possibly to reverse the increasing adverse imbalance between income and expenditure leading to reduced profitability,” says Keith Wood, chief executive officer at SJ Berwin. However, if by December M&A activity picks up then “this increased activity may improve profitability in leading City firms that may restore faith in the current business model”.

As one of the principal writers of the PWC law firm survey, Snell has got a fairly good line of sight as to what’s been happening in the legal profession: “I think the downturn took the profession a bit by surprise and I think the severity of the downturn took people by surprise and really has caused some very fundamental appraisals of the current year and the following years’ budgets and then appraisals and reappraisals.”

While noting that banking and strong recovery/restructuring practices will be the key to having a good 2009, Bull thinks that the very large firms may have a five to ten per cent reduction in profits and that it will be very mixed profit experiences for medium-large firms, although they will “generally find themselves coping with the extreme impacts of a recession”. As for the medium to smaller firms, “a very large number… are going to have a very tough year and will need excellent financial management to weather that storm”.

Redundancies and headcount

Following a noticeable initial reluctance to cut back, something perceived as a ‘last resort’, recent headlines have shown that firms are cutting quite hard – probably quite a good strategy in light of what we have seen happening more recently, explains Snell.

‘Trimming the fat’ is the expression du jour, and appears to be the position that most firms are adopting. “I think most people have been cutting away some of the fat around some of the firms that has built up in more prosperous times,” explains Giles Murphy, a director at Smith and Williamson who deals with professional practices. “If things don’t improve, firms will be forced to start cutting away at some of the muscle, which will have deeper and longer term implications for any recovery.”

Cutting away at the ‘muscle’ would invariably suggest focusing on partners and equity partners, keeping those who are good at executing deals, good at developing and working with clients, and good at sourcing new work. “In this environment, some partners flourish, absolutely focused on getting out there grabbing every opportunity and thriving in this environment – they may not be winning a huge amount of work but they are loving the opportunity to really prove themselves,” Murphy explains. “Others are sitting in their offices staring at the walls not sure what to do next” – something that may not have been noticed during the busy times, but will have become patently obvious in the downturn.

So if your profitability per partner is down, then the advice is to look at previous recessions and follow the example of accounting firms and reduce the number of equity partners. “Firms have to take tough decisions about employees and partners so they don’t end up with too large a firm to sustain – because the emphasis is now on sustainability of the business,” says Bull.

While there are health benefits to losing weight, caution must be advised so as not to cut so deep as to adversely affect the firm’s culture and ability to service clients in the upturn. Do it right, however, and the benefits will follow. Looking back at previous recessions, “what happened is that the better businesses came out of it much leaner and fitter as a result,” explains Green. “They identified flab that had built up over the years and just cut it out, ensuring their organisations became better positioned in terms of focus and cost base”.

Cash flow and cutting costs

Working capital management will be a major focus in 2009. Cash must be carefully conserved, billed and collected as banks continue to be unwilling to lend – in particular, “firms that have large working capital requirements and are reliant on continuing growth to fund the practice and maintain profits are having a tough time” says Bull. Firms need to ensure manageable cash flow as “working capital management is deteriorating for many as clients are taking longer to pay,” says Snell, “and the management and billing of work in progress becomes more difficult in a recession”.

Keeping a very close eye on work in progress and discerning what is truly billable and recoverable is extremely important. Especially “if your internal management processes aren’t good or are weak,” explains Snell, “then in the current climate clients are going to take advantage of that and are going to take longer to pay you”.

Cash management is clearly critical, but so are cutting costs and controlling expenditure. In a recession, although a firm may continue to be profitable, “if you aren’t controlling your cash in and cash out,” says Bull, “then you can still fail because you simply can’t afford to carry on because you haven’t got the cash”.

The marketing budget is usually among the first to be cut. However, in the long-run and especially when the economy picks up, those that continue to market themselves through a downturn will be far better placed to take advantage of the inevitable upturn. Now is not the time to hide away.

Spend on support staff, IT, business development and recruitment, for example, needs to be carefully examined; however holding onto a long-term view is important. “We’re still taking on graduates, we’re still taking on our trainees,” says Green, “and we still have a commitment to develop and invest in our people, because for us they are the firm’s future”. So spend, just do it wisely – concentrate on the necessary and postpone the not-so-necessary.

Mergers, consolidation and the LSA

“I fear that quite a few mergers, if they do come around, will be out of adversity,” says Snell, and in his experience, the difficulties with mergers are that they “tend to focus you in on yourself, just at a time when one ought to be focusing on the market and growing market share.”

There’s a lot more ‘merger chatter’ going on in the market place, says Murphy, with the euphemism being that when someone says ‘could we meet up for a cup of coffee’, “you might as well say can we meet up to discuss a merger.”

Many firms may need to undergo significant consolidation, maybe as a defensive measure to stay in business, cut back on their cost base or to support overseas expansion so as not to rely so heavily on the UK economy – a lesson many have learnt the hard way.

Quite a number of strong well-managed firms are finding opportunities in the recession to rescue firms that are failing, explains Bull, so as to build out areas that are profitable for them and where they want to expand. Equally, “smaller, quality firms that are struggling are finding that they can talk to white knights who may rescue them,” he says, “and many firms are engaged in opportunist or defensive merger talks”.

Due to the financial position of many firms, the opportunity for consolidation has now been brought forward, says Murphy; however, if it’s done as a last ditched attempt to survive, “clearly merging two poorly performing firms is not going to be a solution to the position either of them are in”.

The advent of LDPs in March could not come at a more interesting, and potentially opportune, time. With financial performance and position being at the forefront of firms’ minds, the opportunity to keep the business running may create much more of an appetite than anticipated. External equity firms are faced with firms that are struggling in this economic climate, and therefore any deals that their consolidators had previously been considering will now be at a much more attractive price.

However, as Snell points out, while firms might be looking at outside investment, in light of current times, “the question is whether anyone is prepared to fund law firms”. However, the state of the economy is so bad that there is generally a very low level of enthusiasm among the individuals to become partners in an LDP, adds Bull.

Clearly, this huge structural change to the profession cannot and should not be ignored, and, as Murphy has been telling people for the past 18 months, “ the LSA is going to have a massive effect on the legal market because any other sector that has felt deregulation has changed immeasurably”.

This change will invariably be approached with much caution, and it remains to be seen what new breed of firm will emerge.

So, how else should firms survive the coming months?

From a management perspective, being prudent, well-managed and very shrewd when managing each different departments’ profits – “firms really need to understand how the recession is going to affect their particular service lines,” explains Bull, “and they will have to become very good at both producing realistic budgets and managing departments very carefully”.

Strength of management and more sophisticated financial discipline will be extremely important, and well-capitalised firms that operate in credit, and maintain tight control over lock up, will be better placed to see out the downturn, says Jennings. In particular, “it is more vital than ever to keep a close eye on forecast cash flows and to react to trends before they become problems”.

For Jon Miller, director of finance at Pannone LLP, the strict management of costs will be necessary “to ensure that reasonable profit margins can be maintained”. And at Mayer Brown LLP, the focus is on liquidity and cash flow. “We need to put much more effort into get our outstanding monies collected,” says Kay-Uwe Bartels, director of finance at Mayer Brown LLP Germany, “and we are focusing on a top-20 client programme and trying to concentrate more than in the past on defined areas”.

Snell sees taking lower profit shares, reducing profits per equity partner and reducing current period drawings as actions that many firms will take, and that there will also be “a long and hard look at under-performing partners, with an emphasis on partners who are proven winners of work”.

And firms would be nothing without their clients, firms must realise that clients are an enormously valuable asset, explains Bull, and so “spend lots of time with your clients. If partners haven’t got enough to do they should be out there supporting clients and developing better relationships with them, helping their clients through the difficult times”.

Turn bad [times] into good [opportunities]?

While the overriding focus is currently on the ‘doom and gloom’, those that take this crisis and turn it around to their advantage will be better placed to come out on top once things improve. Identifying and seizing the opportunities that will invariably arise will ensure that firms are best set to ride the recession and service their clients in the upturn.

Firms have the opportunity to streamline their businesses so that they are in the best position possible when the economy improves. At Pannone LLP, they have used this opportunity to “internally impress upon partners the importance of financial management across the whole firm,” explains Miller, “and to introduce procedures to best encourage this”.

As partners and management have more time on their hands due to the decline in activity, now is the time to take care of any operational, organisational and administrative tasks/projects that have previously taken a backseat. Partners should be encouraged to delegate work down the chain, both to save on hourly rates and to dedicate more time to firm management.

This recession will truly test the quality of a firm’s management, and any previous partner reluctance to be managed needs to be quickly overcome. Better management disciplines must be introduced and getting partners to function as a managed team rather than a group of individuals.

At Herbert Smith, they have been pushing through some necessary organisational and procedural changes “that would have been more difficult to do in a buoyant market,” says Green – “so in some senses, the economic downturn has made my job a little bit easier!”

As Wood points out, “this downturn should be used as a sanity check on operational efficiencies and cost effective processes that may have slipped off the centre of the radar screen during the past three years of excellent profitability.” At SJ Berwin, he says the downturn will also help them to focus on imaginative and supportive discussions with clients relating to their business opportunities in spite of, or in some cases because of, the economic downturn – “this is particularly important for us to defend our client relationships from marauding magic circle firms keen to fill their order book”.

And as Bull highlights, there are currently big lessons to be learned, in particular regarding: genuine close client relationships; understanding how to compete on quality of service, relationship and price; very good financial management; preparing and managing robust budgets; having a clear understanding about how your firm makes its profits; and, cash control.

To capitalise on opportunities, planning is key – outline all the ‘what-if scenarios’ and make a plan for each, enabling the firm to react quickly as things change. And don’t just have a plan A – you need a plan B, C, D and E. “What firms have to do is to plan for different outcomes,” says Snell. The right way to do this is to think “if there is a small upturn towards the end of 2009 or a levelling off what would we do then? If there is an upturn in 2010 what would our response be then?”

So, a recession, a depression and an ailing profession?

We will, at some point, come out of this crisis, and although the process itself will not be without casualties, the end result could be rather cathartic for the profession. “While nobody wished this financial crisis on us,” says Jennings, “I do believe that stronger managed firms will ultimately benefit when conditions improve as they will be best placed to take advantage.”

The general view is that many are expecting the economy to pick up in the first or second quarter of 2010. And timing is crucial to a firm’s position on the starting blocks come the upturn. But with the massive amount of uncertainty and instability out there, predicting exactly when that ‘time’ is, will be critical – get the timing right, and you will find yourself at the front of the pack. Get it wrong, and you could be in serious trouble.

What will become apparent will be those firms that are really well run, well-managed and financially well-funded, says Murphy, “with a sustainable and flexible business plan that’s not built upon certain factors outside of their control”.

The predictions are for a long and hard recession – but many see it as the kick-start the profession needs to implement change that has been a long time coming.

And the profession is not without hope: “I know we will come out of it better, healthier and fitter as a result” says Green.

However long it lasts, there will be a period of recovery where gaining back client confidence and rebuilding firm business and balance sheets will be key – and those that have planned, planned and planned some more will be the ones that come out on top: “For the better-managed firms, this is almost a once in a generation opportunity, if they get the timing right,” explains Murphy. “The brave firms, the ones who see it as a good opportunity, can really make a step change in the current environment, move up the table, whether that is in quality, profitability or size and essentially overtake some weaker competitors.”

No one can predict with certainty what the next 12 months will bring, but in answer to the question ‘2009 – a recession, a depression and an ailing profession?’ we can, with certainty, respond as follows:

Recession? Definitely.
Depression? Maybe.
An ailing profession? A resounding ‘no’.